Will climate risk trigger the next great financial crisis?

March 28, 2024|Written by and
Flags outside the New York Stock Exchange
© Carlos Delgado

This year marks a big anniversary – 15 years since one of the biggest meltdowns in financial history. For a few weeks in the fall of 2008, the world’s financial system teetered on the brink of collapse and threatened to push the world into a global depression unseen since the 1930s.

One of history’s most important lessons is how often we forget it, which is why this anniversary is so significant. So what did we learn from the great financial crisis of 2008-2009? And how might these lessons apply to the rapidly escalating financial risk of climate change?

First and foremost, the financial crisis reminds us that while large global banks are among the most sophisticated managers of financial risks on the planet, sometimes their models just don’t account for all factors that could cost stakeholders billions, if not trillions, of dollars.

Linked to that is the even bigger takeaway which has enormous implications for today’s market: these financial institutions can also underestimate how quickly things can spiral out of control.

In retrospect, a vital lesson of previous financial crises is that bank time horizons for modeling risk often made them assume they had more time to act before adjusting course. This happened in 2008 when financial actors across the globe became enmeshed in the unexpected collapse of a housing bubble and the sub-prime loan market built around it.

It wasn’t simply that banks were mispricing these large and correlated assets. They also underestimated how quickly that widespread risk could implode and how little time they would have to respond. It was a heavy price to pay: billions were lost in a matter of weeks, causing significant devastation to corporate and personal portfolios alike and costing the global economy upwards of US$2tn, a 4% decline in global economic growth.

Climate risk could come faster than banks expect

Fast-forward 15 years and a new risk – climate risk – could cause the financial system to spiral out of control just as fast and with even greater impact than the financial crisis. In a perfect world, the shift to a low-carbon economy would happen smoothly and be globally coordinated. Asset values would slowly change and banks and investors would have plenty of time to adjust their portfolios.

Banks are beginning to address these risks. They have moved (slowly) to de-risk their portfolios while opining that most of the risk is post-2030. They are setting goals for zeroing out emissions in their portfolios and investments, and investing in transition finance. Banks also acknowledge that climate risk is a possible systemic risk.

All of this is progress. However, banks just need to move faster because changes happen, as Hemingway wrote, in “two ways: gradually then suddenly”. And our world today is far from “smooth and globally coordinated”, to say the least.

As Ceres’ 2020 report on transition risk warned, the risk of a disorderly transition is growing rapidly, significantly raising the possibility of sudden shocks to asset values. While some in the financial community are uncertain about the possibility of a climate-driven liquidity crisis, our research shows that climate-related factors could rapidly increase the risk of financial contagion and potentially a system-wide disaster.

Unfortunately, the timing of such a shock is highly unpredictable. But we have a good idea of how the scenario could play out. A rapid devaluation of fossil-fuel-linked assets could trigger involuntary “fire sales”, where banks are forced to sell at any price to meet regulatory capital requirements, triggering a short-term liquidity crisis like the one in 2008.

No financial institution is immune

Only this time, the stakes are even higher. In just 25 years, climate risk could cost the global economy $23tn annually, slashing global economic growth by between 11% and 14% according to estimates by global insurer Swiss Re. In the US, National Oceanic and Atmospheric Administration maps and the Federal Emergency Management Agency’s national risk index map highlight the massive scope of the problem.

This is challenging news to banks that provide vast amounts of capital across the economy, as many of their clients’ projects and capital investments increase their exposure to climate risk. The risk results from the wide-ranging physical impacts of climate change but also the transition risks posed by regulatory, technology and litigation changes during the shift to a low-carbon economy.

Equally at risk are the nation’s mid-size banks and credit unions, which face escalating climate exposures due to sectoral and geographical concentration that could pose a significant medium and longer-term financial risk. There are short-term risks as well, as shown by two credit unions that closed due to the impacts of Hurricane Katrina.

Another key lesson of 2008 was the crucial role of regulators. As US regulators review potential changes to bank risk management rules, they should consider the impact on clean energy activities and vulnerable communities. Separately, the federal and state banking regulators need to do more to require and support through disclosure and scenario analysis – from banks and financial institutions of all sizes.

As Securities and Exchange Commission chair Gary Gensler said recently: “At 40% of the world’s capital markets, [US capital markets] outpace our 24% share of the world economy.” But much like we do not allow other vital industries, including insurance and utilities, to regulate themselves, bank risk managers should not be the sole voice in deciding how to keep our economy safe from future bank failures.

America’s disproportionate impact on global financial stability

Now is the time to act. How the US prepares for a future climate financial crisis is crucial, given its outsized impact on a dollar-based global financial system. With an unprecedented number of climate disasters regularly making news headlines nationwide, the stakes are much higher than in 2008.

Banks, regulators, investors and customers must move faster to make the sector resilient to short and long-term shocks and ensure our markets are safe and secure in the face of risks that could manifest in cumulative and unexpected ways. And faster than we ever thought.

While risks are significant, there are also trillions in current and emerging sustainable finance opportunities. Savvy firms can bet against the worst-case climate scenario and make considerable sums of money, for example by leveraging the subsidies and tax credits contained in President Biden’s Inflation Reduction Act and getting ahead of competitors in the industries that will drive the future growth of the US and global economies.

This page was last updated July 4, 2024

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